In the figure below, the economy is initially in long-run equilibrium at point A If there is an adverse supply shock that reduces potential output and shifts the long-run aggregate supply curve from LRAS to LRAS', then there is initially _____ gap and the short-run aggregate supply curve will _____.

A) an expansionary; eventually shift to SRAS'
B) an expansionary: eventually shift to SRAS"
C) a recessionary; eventually shift to SRAS"
D) a recessionary; eventually shift to SRAS'

Question

In the figure below, the economy is initially in long-run equilibrium at point A If there is an adverse supply shock that reduces potential output and shifts the long-run aggregate supply curve from LRAS to LRAS', then there is initially _____ gap and the short-run aggregate supply curve will _____.

A) an expansionary; eventually shift to SRAS' 
B) an expansionary: eventually shift to SRAS" 
C) a recessionary; eventually shift to SRAS" 
D) a recessionary; eventually shift to SRAS'

Quizplus · Accepted Answer

The decline in potential output creates an expansionary gap in the short run as the economy is still at point A. As inflation rises, the short-run aggregate supply line shifts upward from SRAS to SRAS' and a new long run equilibrium is reached at point C. The long run result of a fall in potential output is a permanent decline in output and a higher inflation rate.

In the Figure Below, the Economy Is Initially in Long-Run